Good afternoon, and welcome to the F5 Networks Third Quarter Fiscal 2019 Financial Results Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. [Operator Instructions] Also, today's conference is being recorded. If anyone has any objections, please disconnect at this time. I would now turn the call over to Ms. Suzanne DuLong. Ma'am you may begin.

Hello and welcome. I'm Suzanne DuLong, F5's Vice President of Investor Relations. Francois Locoh-Donou, F5's President and CEO; and Frank Pelzer, F5's Executive Vice President and CFO, will be making prepared remarks on today's call. Other members of the F5 executive team are also on hand to answer questions during the Q&A portion of the call. A copy of today's press release is available on our website at f5.com where an archived version of today's call also will be available through October 24, 2019. A replay of today's discussion will be available through midnight Pacific Time tomorrow, July 25th by dialing 800-585-8367 or 416-621-4642. For additional information or follow-up questions, please reach out to me directly at s.dulong@f5.com. Our discussion today will contain forward-looking statements, which includes words such as believe, anticipate, expect, and target. These forward-looking statements involve uncertainties and risks that may cause our actual results to differ materially from those expressed or implied by these statements. Factors that may affect our results are summarized in the press release announcing our financial results and described in detail in our SEC filings. Please note that F5 has no duty to update any information presented on this call. With that, I'll turn the call over to Francois.

Thank you, Suzanne, and good afternoon, everyone. Thank you for joining us today. I'll talk briefly to our business drivers before handing over to Frank to review the quarter's results in detail. We continue to aggressively execute our strategy of transitioning F5 to a software-driven model. From our efforts to reprioritize our development resources to the introduction of new, flexible consumption models, and most recently, the acquisition and integration of NGINX, customers are seeing a new F5. We believe the steps we have taken including very deliberate go-to-market changes are accelerating our transition to a software-driven business while driving overall product revenue growth. As a result, it is no longer accurate to view F5 through the narrow lens of a traditional ADC player. In Q3, we delivered 4% total revenue growth and 3% product revenue growth with 79% organic software growth. If we include the partial quarter of NGINX, our software growth was 91%. Our exceptional software growth in the quarter is being driven by security use cases, including web application firewall, and bot-defense and mitigation. The quarter also included a few multimillion dollar ELA deals. Software growth was partially offset by our systems business, which was down 11%. Our services business delivered 4% revenue growth in the quarter and continues to produce robust gross margins with consistently strong attach rates. I will speak more to our business dynamics and the NGINX integration later in my remarks. Overall, the team is executing very well against our long-term strategy. We believe with the combination of NGINX, we are exceedingly well-positioned to capitalize on continued application growth in a rapidly evolving application services landscape. Frank?

Thank you, Francois, and good afternoon, everyone. As Francois noted, we delivered another quarter of strong revenue and EPS growth. As you know, we closed the acquisition of NGINX on May 8th, and our Q3 results include NGINX from that point through quarter-end. As a reminder, our guidance for Q3 revenue and earnings was set prior to the close of the NGINX acquisition, and accordingly did not include any impact related to NGINX' results. For this quarter only, during my remarks I will break out NGINX's contribution to several Q3 performance metrics. Going forward, NGINX's contribution will be fully integrated into our results and guidance. Third quarter revenue of $563 million was up approximately 4% year-over-year. NGINX contributed $5.1 million in the period. Excluding NGINX's contribution, we delivered revenue of $558 million, near the top end of our guided range of $550 million to $560 million. GAAP EPS was $1.43 per share, and non-GAAP EPS was $2.52 per share. Excluding the impact of NGINX, non-GAAP EPS would have been $2.57 per share, at the top end of our guidance range. Q3 product revenue of $249 million was up 4% year-over-year and accounted for approximately 44% of total revenue. NGINX contributed $4 million to product revenue in the quarter, all of which was subscription software revenue. As Francois mentioned, software grew 91% year-over-year and represented approximately 27% of product revenue, up from Q2 when it was approximately 19% of product revenue. Excluding NGINX, software revenue grew 79% year-over-year and represented 26% of product revenue. In the quarter, we had very strong uptake on our software solutions sold as ELAs and annual subscriptions. Under the modified retrospective approach to ASC 606, we are required to compare our results under 606 to what they would have been under 605 during the first year…

Thank you, Frank. I'll spend just a few minutes on the trends we're seeing in the business as well as the NGINX integration before moving to Q&A. F5 today is very different than the F5 of even 24 months ago. A year ago in March, we laid out our strategy for transitioning F5 to a software-driven model. Since then, the team has been executing on that strategy and making deliberate changes that have substantially reshaped F5 and our growth opportunities. What do I mean by that? In the last 24 months, we have, number one, executed a wholesale reprioritization of our resources, aligning the business with our growth priorities; number two, introduced new consumption models like subscriptions and ELAs that make it easier for customers to purchase and deploy F5 application services and software; number three, we have doubled down on security, including investments in WAF and bot mitigation; and number four, we have also brought new solutions to market, solutions like Cloud Edition and central management, orchestration and APIs, all of which have opened a new opportunities for us. As a result, it is no longer accurate to view F5 through the narrow lens of a traditional ADC player. Our efforts to expand our reach and broaden our role have accelerated our software transition, and it is becoming evident in our performance. And this is true even before we factor in future software growth catalyst, including NGINX and F5 Cloud Services. Today, F5 is a leader in an emerging and rapidly expanding multi-cloud application services space, a space that has arguably been underserved, which is why we are generating the kind of software growth we are. The multi-cloud application services opportunity differs from the traditional ADC opportunity in three fundamental ways. First, multi-cloud application services offer customers a much…

Thank you. [Operator Instructions] Your first question comes from the line of Alex Kurtz from KeyBanc Capital Markets. Your line is open.

Yes. Thanks guys for taking the question. Just on the impact from software which is really great to see, Francois, in the quarter. Any dynamics around how customers are consuming it and -- these comments are excluding NGINX for a second, but just, would it means for deals size? What does it mean for how the revenue is being recognized in the quarter and how we should think about that relative to systems business?

Hey, Alex, I'll take the first part and perhaps Frank can comment on the revenue recognition portion. So, the way that our customers are consuming our software is both via perpetual licenses and also via ELAs, which are typically three-year subscription agreements, and also one year subscriptions. The part of the business in software that has the fastest growth is in fact the subscription portion of the business because it gives our customers a lot more flexibility in terms of their own cost models and also the ability to consume the features as they go. So, we're seeing a lot of traction with these consumption models. And we're seeing a range of deals -- to your point around deal size, ranges from small kind of one year subscription that are typically multiple tens of Ks all the way to multimillion dollar, three-year enterprise license agreements.

And Alex, with the adoption of 606 this year, the revenue recognition associated with a lot of subscription deals look exactly like what we would have had as perpetual deal in previous years. And so, instead of radically recognizing, you split out the value components and recognize that proportion of the revenue, which is frankly modeled after our perpetual. So, on a year-over-year comparison, it's very, very close to the same.

Your next question comes from line of Paul Silverstein from Cowen. Your line is open.

I appreciate it. A couple if I may. First off, my math must be wrong, but on the software revenue, I'm coming out to $67 million in the current fiscal Q3, $65 million, if we exclude NGINX, this is what you said versus $45 million a year ago, that will work out to 42% year-over-year growth, not this 79% organic and 91% in total. Can you just help me out with the numbers? Because I mishear you all, it was 19% of product revenue a year ago and 27% in the current quarter, 26% ex-NGINX?

So, I think, your number, Paul, for this year is correct, so the number for last year is not. It's much lower. I think it's something close to $34 million or $35 million.

Did you all not do $239 million of product revenue last quarter in the year ago quarter?

Yes, about 239.

19% of $239 million is $45 million.

19% that I referenced was last quarter, not a year ago quarter.

My apologies. What was it in a year ago quarter?

I think, it was -- I'm doing this off memory, but I think it was about 14%.

14? All right. I'll come back to you after the call on that. Secondly, related to software NGINX in particular. I think, there's a view out there among most investors that NGINX displaces existing F5 platforms. And you all bought Silverline back when previous acquisition; you were working hard on it, if I recall the past two plus years. Can you just clarify whether NGINX totally displaced what you've done with respect to cloud platforms, whether it augments? And then, I've got a quick question on VMware, Avi.

Paul, thanks for the question. On NGINX, no, it does not displace either our perpetual software, sort of virtual edition offerings or Silverline. So, Silverline is essentially a managed security services platform for customers that want to consume WAF and DDoS and other security services with associated 24x7 support and leveraging our infrastructure to scrub the traffic and provide managed services to them. NGINX is a great platform for DevOps' environment, essentially injecting application services in the code of application logic. And it plays to a very different market than the market we have played in to-date, either with Silverline or with our Virtual Editions.

Frank, before I ask the Avi question, what percent of your total revenue is now recurring?

I would say, it’s north of 70%, including the services fees.

Do you know what it was a year ago?

I’d have to get back to you on that one, Paul. I don't have that off the top of my head.

If you could, that’d be appreciated. Now, for the Avi question. So, Avi was talking really good game before got acquired and it just got acquired by VMware. Obviously that wins resources, incumbency, customer base all things are needless to say. I know, it hasn't been a long time, but what are you seeing in terms of their success or lack thereof currently, versus whatever degree of success they were having previously in competition against you?

I know this one has gathered quite a bit of interest after the VMware acquisition. So, I am going to take the time to answer your question thoroughly and put a few facts on the table. So, Avi is essentially a software load balancer with the value proposition around nice analytics and nice GOE. [Ph] And where that value prop plays is in use cases where a customer would value the GOE [ph] and analytics over having a truly lightweight, truly scalable solution. And I’ll tell you that this is actually a very small fraction of the market. And let me be specific about that. Historically, we have seen them in less than 2% of our deals. Even when we’ve seen them, we win the large majority of these deals. Even in the light -- the accounts that they have claimed to be lighthouse accounts for them, we’ve looked at them, and F5 sales for the most part has 95% or more of the wallet share we ADC in these accounts. And then, going back to some of these lighthouse accounts, we’ve seen a number of customers that are coming back to F5 from Avi because of lack of scale, lack of features or difficulty in getting the stock operationlized. So, that’s where historically things have been. And I just wanted to make sure the facts were clear on that. Now, VMware is a great company. We have a lot of respect for them, we do partner with them. And of course they’re going to provide larger distribution for Avi. But where I think this is going to play out is the VMware Avi proposition I think will appeal to customers who’ve gone all in on NSX and value, deep integration between NSX and a software load balancer, more than…

Your next question comes from the line of Sami Badri from Credit Suisse. Your line is open.

Thank you. So, I just had a quick question first on some of your cash, right, and where your cash balance is going to be by about mid-year 2020, or like at least the next fiscal year, basically two to three quarters from where we are today? I just wanted to understand maybe what the corporate plan was, what you're going to do with this cash balance? Are you going to consider more M&A? Are you going to potentially reinstate your cash buyback? Would you consider some other factors? Just to give us a bit of an idea on what you're going to do with this quickly escalating cash balance?

Hi, Sami. Look, I think, you can look at it this way. We are -- for now, we're placing significant emphasis and focus on augmenting our balance sheet and rebuilding our cash balance. But, we're going to continue to look at opportunities in the marketplace, whether it's potential M&A, or if the opportunity presents itself potentially more buyback. All these options are on the table. But in the very short-term, there is more emphasis on rebuilding our cash balance.

Got it. Thank you. And then, my next question had a lot to do with, given the formation of some of the new offerings, F5 and NGINX are coming together and go to market with, would it would it be safe to assume that systems revenues specifically, or at least, the growth rate, or I guess you said, the declines could accelerate in probably six months out from today, given that the fair majority of the new offerings coming to market are more software-based versus hardware. And this is also probably a bit more correlated with the IT backdrop that you kind of see, see some metrics start to decelerate in a broader macro IT world, could you potentially see further deceleration of growth in the system side and then naturally see some acceleration further in the software side?

I don't necessarily think that the factors you mentioned, Sami, would lead to further deceleration on the hardware side, because there are also other sort of compensating factors when you look in 2020. I think, we should probably see a bit more from service provider around sort of capacity upgrades that are more naturally hardware driven. We also have some evolution of our own platforms, hardware platforms that would contribute to that. So, I think, there are factors on both sides of that equation. We've taken all of that into account when we have given our guidance for Horizon 1 around mid-single-digit growth. And I think we're still comfortable with that guidance. Now, in that guidance, Sami, what our thought was that hardware would decline sort of low-single-digit to flat and software would go in the 35% to 40% range. Given what we've seen over the last six months, I think, it's fair to say that software is going to grow a little faster and hardware is going to decline, also a little faster than what we thought. But at this point, it's hard to give you a hard answer on the exact numbers for each. But overall, we're still seeing the balance of revenue growth is going to be what we thought.

Got it. Thank you. And then, my last question has to do with the APAC deal regarding the carrier. And just to give us an idea, could you give us an idea on mix on software versus hardware in terms of what this carrier bought from you guys, just so we have like maybe some kind of illustration on what future carrier deals could look like?

Sami, it's a good example of a carrier that is moving to NFV in anticipation of the 5G rollout. And in this case, they bought software, essentially. It was a 100% software ELA with a number of virtual functions included in the deal.

Your next question comes from the line of Rod Hall from Goldman Sachs. Your line is open.

I guess, I wanted to go back to this question of systems and systems decline and ask you what you think your market share position looks like for the quarter? Like, do you think you've maintained share? Do you think you lost share? And then, what would you expect to happen in the future, like the next few quarters? Do you think that within the systems business for ADC you’ll be able to maintain share and just kind of track more performance or would you expect to kind of outperform the market itself?

Well, Rod, I think, if you look at -- first of all, I think, looking at just the ADC markets, the fairly narrow lens to look at when it comes to F5, now, as I said in my prepared remarks, I think, we're really becoming more of a multi9cloud application services player. And I think that's a broader opportunity. Now, that being said, if you’re going to look with the lens of the ADC market, overall, hardware and software, I definitely think we're gaining share. Specifically in the hardware space, how we gained share this quarter, I can't tell, I can't answer that. And we won't know until market share reports come out in a couple of quarters. But, what I can tell you is there are things that we have done that have deliberate actions for my F5 that are transitioning some of our hardware business to software. And then, this includes things we do in our software offers to make them much easier to consume and remove all of the friction that exists in our customers adopting these solutions. It also revolves around the commercial offerings and the way we structured and changed our contracting structure. And it also revolves around the things we've done on go-to-market and the incentives we’ve put in our field teams to proactively help customers who want to transition to software faster platform. And so, those actions are driven by us. Of course, there are effects that have to do with the market. And customers themselves wanted to implement software policies, and also wanting to have this multi-cloud portability, which is made easier with software. But, so, when you look at these two factors, that's what I think is driving the decline in systems, but some of which is driven by us. And the last point Rod is, we have not been losing -- if that's kind of what you're getting to, we have not been losing hardware deals, if this is your question. We actually continue to be very, very happy with the win rate on our hardware deals.

Yes. No, my -- the angle of my question was more you guys have been gaining share in hardware. And I wondered if you thought you would sustain that or whether you thought maybe you would match kind of the hardware market more, but that was kind of where I was coming from. And I also wanted to ask Francois, given the high software growth in the quarter, what -- can you give us any idea what you think software growth you did for the market or even better, it looks like over the next year, I mean, are you thinking that you can maintain this kind of ballpark in terms of growth, or is this a one-off or what sort of growth do you think is likely as we look out?

I think, Rod, if you look at the analysts’ reports on ADC’s software growth, excluding -- by the way, my comments here exclude ADC-as-a-service, which is largely the latest cloud offering. I’ll come back to that in a moment. But if you exclude them, the analysts’ reports so far are pointed to say 20%ish growth rate in the ADC software market. And so, if you look at that, we definitely believe that we are gaining a significant share in the ADC software market, even though our software growth isn’t just driven by ADC, it’s also -- it also has a strong component of security which has very strong software growth. So, that’s kind of when you look at things today. So, your question around can we maintain the software growth in the coming quarters? Look, I don’t expect 90% software growth every quarter. And as I said before, I think we -- my expectation is that we are likely to do better than the 35% to 40% software growth that was put in our Horizon 1 guidance, in part because we have growth catalysts that haven’t played out yet, specifically NGINX and also F5 Cloud Services, which is more of a sort of back half of 2020 contributor and certainly a contributor in Horizon 2. So, I think both of those catalysts that are yet to materialize for us. But overall when you combine that and what’s happening with hardware I still think what we’ve shared with you for Horizon 1 is about - overall aggregate revenue growth for Horizon 1 is correct.

Your next question comes from the line of Jeff Kvaal from Nomura. Your line is open.

Thank you. Yes, I have two questions. I think, first Francois for you. There is a tremendous success in software this quarter, does put you on a much higher trajectory when it comes to that piece of the business. But, it doesn’t seem as though your overall corporate growth rates have picked up, despite the software explosion. And I guess I would have expected there to be a little bit of uptick in the overall corporate growth rate, if you are expanding into standalone security et cetera, et cetera. So, I was wondering if you could offer some thoughts about that. And then, Frank, on your side, the OpEx number that you are offering us for the September quarter is a little higher than we’ve modeled, and there is integration of an acquisition, so I get that. But I was just wondering if you could help us understand where the OpEx is and where it might go over the course of the fiscal year, to the extent you can. Thank you.

I’ll take the first part. And look, I think this is -- if you look at our overall revenue growth, this is playing out so far pretty much in line with what we have shared at AIM and what we have shared when we made the NGINX acquisition in terms of overall aggregate revenue growth. And I think we shared that in our Horizon 2, we expected this to pick up. And that’s still our view. But for Horizon 1, I think when you look at the dynamics combined of the transition we have to go through as a company, starting from a large base of hardware and transitioning to a majority software business, that's how it's playing out. And I think the growth rate reflects that for the time being.

And Jeff, in terms of non-GAAP operating margin for the rest of our fiscal year, the coming quarter that we have is the rest of our fiscal year. And so, we're not providing any guidance at this point for FY20. But, as we talked about in the acquisition of NGINX, we expected that our non-GAAP operating margin in Horizon 1 was going to be in the range of 33% to 35%. This is absolutely in that range. And we did that with the anticipation of the expenses that were going to come on through the NGINX acquisition. So, that's exactly what we're seeing.

Your next question comes from the line of Samik Chatterjee from J.P. Morgan. Your line is open.

Hi. Thanks for taking the question. Francois, I just wanted to start off with a more broader question on what are you seeing in terms of spending trends from enterprise customers? I think, last quarter, particularly there were few companies that had mentioned, given the uncertain macro, there was some kind of softness in signing large deals. What are you seeing on the ground? Are you seeing kind of any hesitation in signing those large deals at this point?

Hi, Samik. I would, maybe give you a couple of pointers. Overall, I think the macro environment is less healthy than it was a year ago. It's not -- I wouldn't characterize it as being kind of difficult but it is not as healthy as it was a year ago. Where we're seeing specific areas of softness, I would say, the UK and Germany and for us in Europe, and specifically the UK where uncertainty persists and we have seen a number of deals there being delayed or cancelled altogether. And I would also say specifically in hardware, we continue to see more scrutiny applied to hardware deals, of course, especially in companies that have software first policies. And so, that probably elongates the deal cycle, specifically for hardware deals.

Got it. Frank, I think, to quickly follow-up with a question on the software side. You had very strong sequential growth in the software revenues and you mentioned most -- a lot of that was driven by the security products. You also launched new SaaS offerings I think I believe in March. Can you just kind of help us understand if the sequential growth, how much contribution was there from the new SaaS offerings or if it’s immaterial now, how much time do you think it takes to ramp those up so that they become material to your kind of outlook?

Yes, Samik. So, we are -- yes, you're right, we launched F5 Cloud Services, our SaaS platform in March, and introduced our first service on the platform, which is DNS-as-a-service. And we're now, in the process of launching our next set of service -- global server load balancing actually is next and is going to -- achieve pretty soon followed by WAF-as-a-Service, et cetera. So, we are -- where we are is we're very early days. And we basically just have the first service but even on the first service, we already have the first paying customers on the platform. And we have a large number of customers in trial and we expect that the pickup will accelerate as we introduce the new service, like GSLB and WAF. In terms of -- so this obviously did not contribute to the quarter. We don't expect it to be really material, certainly not in the next three quarters. SaaS businesses have a -- take a bit of time to ramp. But certainly going into FY21 and ‘22, when we get into Horizon 2, we would expect our F5 Cloud Services platform to be a meaningful contributor to our overall business and certainly to our software growth.

The next question comes from the line of James Faucette from Morgan Stanley. Your line is open.

Great. This is Meta Marshall for James. Maybe first question, understanding that the 33% to 35% OpEx is kind of within the Horizon 1 that you had noted, but just also you kind of noted that change to the go-to-market. And so, I just want to get a sense of how much of this is just layering in NGINX versus how much of this is kind of -- is there a cost to kind of the change in go-to-market approach? And then, maybe the second question, just if you -- if we could get a sense of what is the impact of the purchase accounting on NGINX for kind of your forecast of just -- you've mentioned it's an $8 million contribution in the quarter. What would that have been without kind of the purchase accounting adjustment? Thanks.

Meta, I'll take the first part, and Frank will take the second part. On the 33% to 35% operating profit guidance for Horizon 1, Meta, this is mainly due to investments in our software platforms, largely NGINX and the investments we have to do there, some of F5 Cloud Services, but it's mainly NGINX. And it's not really about the go-to-market, it’s a change in the go-to-market models. Even though we have increased the size of our go-to-market teams with the addition of NGINX, this is more about the platforms than a fundamental change in our go-to-market.

I mean, in relation to the $8 million, that was a discussion about the contribution of NGINX next quarter. Without a purchase accounting, my assumption is that would be just approximately $10 million, maybe slightly more than $10 million next quarter?

Your next question comes from the line of Simon Leopold from Raymond James. Your line is open.

I wanted to maybe come at the OpEx question a little bit differently. I want to reflect on the June quarter. Excluding the acquisition you had forecast, I believe, $275 million to $287 million, which would imply something like 60ish million coming from the acquisition. If you could maybe unpack what occurred in the June quarter and then help us understand what's maybe one-timeish, what's sort of ongoing from the acquisition, because obviously you're forecasting significantly lower operating expenses in September. So, I just want to make sure I understand the moving parts or components to operating expenses?

Sure, Simon. So, all that $60 million, I think where you're getting that figure is when we talk about not just contribution from NGINX, but also some of our non-GAAP things that we have to split out. And that reconciliation can be found in the press release. And so, I'd point you to that. But some of the bigger items where there was a portion of the NGINX acquisition where it was part of the consideration but accounting makes us take that as an expense in the quarter and it was effectively a holdback or leave [ph] for key employees that was part of the deal negotiation. And so that was a large portion of that. There were some facility exit charges. And then the rest of what we would discuss would be the inflow of the new NGINX employees. So, all of that was anticipated as part of our guidance and our guidance going forward.

And so, the incremental expenses from NGINX by itself in terms of what is going to operating expenses is in kind of a $25 million to $30 million range per quarter?

It’s approx -- I think it’s actually, Simon, a little bit less than that but it’s not a number that we’re splitting out for practical purposes. We’ve already combined some of the teams together and it’s not the way we are tracking the business.

Okay. And maybe just to pivot, in terms of the cash position, I understand this is I think the first quarter in more than 10 years that F5 has not bought back stocks, so sort of a significant break in the pattern. What is the cash level that you feel is necessary to run the business because it seems as if you certainly got adequate cash to do everything you’d like and could still buyback stock. So, I guess, I'm trying to really, even if you’re not ready to give us a number, if you can maybe explain your philosophy.

Sure, Simon. I mean, for a long time, we’ve had plenty of cash to run the business and have chosen to do share repurchase as opposed to other things that you can do with cash, including inorganic expansion. And so, we are adding back up that flexibility to continue to use our cash for multiple purposes and we’ll be strategic with it. I can’t say that there is ultimately one level where the cash balance has to be before go back in the market and repurchase shares. That could be this quarter.

Could you maybe just follow that with your thought on instituting a dividend?

Yes. We don’t have any anticipation at this point of instituting a dividend. We think that that’s actually not a great tax efficient way of redistributing cash to our shareholder base, and we’d be much more off to do share repurchases as that vehicle to redistribute cash.

Great. Thanks for taking the questions.

Thank you. Ladies and gentlemen, this concludes today’s conference call. You may now disconnect.